Tariffs, Uncertainty and Market Sentiment
The importance of the bad news principle
Tariffs, Uncertainty and Market Sentiment
The importance of the bad news principle
Pasquale Lucio Scandizzo
As of 19 May 2025, the global economic scenario suggests an outbreak of short-term optimism after a brief tariff confrontation, and a 90 day end game procrastination, between the United States and various trading partners including China, the European Union, the United Kingdom, and India. This temporary respite from trade tensions has induced rallies in stock markets and prompted bullish sentiments in specific industries. But the response reflects the "bad news principle" in markets’ behavior: that investors and companies temporarily respond positively to a temporary easing of negative developments, and underplay or overlook long-term adverse consequences.
In real options theory, the bad news principle, famously stated by Ben Bernanke’s in 1983, prescribes that firms investing under uncertainty need to consider just downside risks. The rationale is that companies have the flexibility to postpone investments and retain the option to invest at a later time. Consequently, firms tend to defer investment when there is a significant likelihood of adverse events occurring. That is, only bad news causes firms to alter behavior — good news never induces action since firms have the flexibility to invest later. This de facto acknowledgement of firms’ rationale behavior, however, tends to be amplified by a cognitive and psychological reaction of relief and optimism. Behavioral economics shows that people fear losses more than they value equivalent gains, making even temporary relief from threats especially impactful. This psychological effect can influence investor sentiment and media tone more than fundamentals. In supply chains, similar cognitive biases cause decision errors under uncertainty, as managers overreact to positive signals and ignore negative ones. As a result, even when firms are rationally holding off on action, markets may rally simply due to emotional relief — creating a temporary disconnect that seems to thrive on good news and yet reinforces the bad news principle’s relevance.
The most prominent manifestation of this phenomenon is in the recent performance of the U.S. stock market. After news about lowered tariffs—such as America reducing Chinese imports from 145% to 30%, and China following suit by reducing its tariffs from 125% to 10%—the Dow Jones rose more than 1,100 points. Comparable increases were seen in the S&P 500 and the Nasdaq due to spikes in tech and retail stocks. Investors seemed to take the truce as an indicator that trade tensions were easing despite its being a specifically stated temporary measure with no assurance that it would be prolonged after 90 days.
Markets also reacted similarly to news that the United States would embark on trade talks anew with the EU, India, and other countries. Vice President JD Vance's Rome and New Delhi diplomacy gave hope that broad deals were going to be enacted soon in lieu of punitive tariffs. The UK and U.S. further launched an Economic Prosperity Deal that could decrease trade barriers for automobiles and farm products. These diplomatic gestures rang out as part of a wider story of progress—although they conceal underlying structural weaknesses and persisting tensions that remain unresolved.
Unintentionally or otherwise, recent actions by the U.S. administration have generated a contradictory set of signals to information. In the short run, they have elicited a relief congruent with the mental aspect of the bad news principle. However, those same actions leave intact a high level of uncertainty and reaffirm the core message of the principle that firms and investors exercise caution when faced with unresolved long-term uncertainty.
This is a revealing example of dual mode operation by the bad news principle. While on one level the news of tariff rollbacks temporarily fosters fear and leads to stock market rallies and short-term optimism, on another level the interim nature of the truce and a lack of structural solutions pins the downside dangers solidly in place. In all cases, this kind of mixed signaling disturbs normal calculations for making an investment. Real options theory predicts that decision-makers tend to defer irreversible commitments while uncertain future conditions persist—even with short-run good news. In this instance, short-run relief is more sedative than stimulus for real investment. It temporarily quiets markets psychologically but does little to encourage real action from companies, who keep an eye out for the full-blown risk of revived tariffs or policy shifts after 90 days.
As markets rally, more profound indicators of economic strain are surfacing and being largely overlooked. Walmart recently issued pending increases on a broad array of consumer staples, including food and child car seats. The big-box stores, Target and Best Buy among them, will likely do likewise. These increases respond to more costly importation due to earlier rounds of tariffs and foreshadow the inflationary pressures that have been building and will likely surge when the truce runs out.
The bad news principle at work is also seen in global companies' inventory and shipping tactics. Global firms are frontloading imports—piling up merchandise during the tariff respite —to escape predicted cost increases later in the year. Ship lines such as Maersk say they see mounting requests for temporary storage of boxes overseas, a tactic likely used to prepare for trade uncertainty more so than optimism over sustained policy stability. Such a tactic shows that a lot of firms see rough times ahead as markets toast short-term victories.
Macroeconomically speaking, red flags are stacking up. In China, while April’s industrial production grew more strongly than anticipated at 6.1%, retail consumption declined more rapidly than predicted. This discrepancy is an indication of softer consumer demand, worrying news for global exporters. But in the European Union, economic prospects have darkened appreciably as well after the European Commission reduced its 2025 GDP growth projection from 1.3% to 0.9% due to mounting trade tensions with the US. And US consumer attitudes have declined for five straight months as families struggle with ubiquitous inflation and uncertainty regarding the path of the economy.
In North America as well, wider trade tensions cast their shadow. There may be an American trade war with Canada and Mexico in making, with virtually across-the-board tariffs—25% on virtually all imports, and 10% on oil—placed by the American government. These tensions to date have attracted less attention than the tension with China but could be as volatile. In total, the world reaction to the 90-day tariff ceasefire illustrates the bad news principle: markets and public discussion fixated intensely upon short-term alleviation, while long-term dangers, revived tariffs, slackened demand, uncertainty due to geopolitics, and inflationary stimulus, are undervalued. Today's optimism might turn out to be brittle, as cancellation of these short-term arrangements could revive trade tensions and volatility in markets. The deeper lesson is apparent: while good news rallies markets rapidly, negative news gets buried—right up to the point at which it comes to be noticed too late.
The market’s seemingly positive counter-reaction to the 90-day tariff ceasefire is also rather ironic, as a neurochemical relief following self-induced tension—like the release of endorphins following voluntarily induced peril. The policies of the US administration first generated economic strain through tariffs and then prompted markets relief by suspending them temporarily. As an echo of the bad news principle, the resultant rally in markets is psychological rather than structural, since relief is achieved from a wound procured by the same hand providing the bandage. As in the case of the brain relief after stress, pleasure feels real but is largely illusory and does nothing to provide a platform for sustained growth and investment.
More worryingly, the apparent rising sentiment in financial markets, while originally comforting, may be unintentionally promoting dangerous policy actions, especially aggressive tariff policies. By insulating past tariff hikes from their economic ramifications, even limited current optimism may send policymakers a message that markets can absorb and even do well irrespective of such disruptive actions. With markets going up due to sentiment and not fundamentals, political figures might be misled into thinking the strength is an indication that markets support, or at least do not mind, protectionism.
In the end, seemingly contradictory behavior driven by the bad new principle and loss aversion may encourage policymakers to pursue more trade battles with minimal downside risk in mind. Such a circularity could increase tariff adventurism and short-change markets enough to produce more economic instabilities in the future. Unless they are underpinned by policies driven by rigorous economic analysis, rather than encouraging governments towards cooperative negotiation, rosy markets could unwittingly legitimize hardball approaches, widening economic uncertainty globally and further reducing the chances for international cooperative dialogue.